Judge Klein of the U.S. Bankruptcy Court (ED California) has allowed the city of Stockton, California to proceed with its chapter 9 bankruptcy case filed last June. Stockton, a city of around 300,000 residents, is the largest city ever to file for chapter 9 bankruptcy protection. The city’s creditors asked Judge Klein to dismiss the case, arguing that the city was acting in bad faith as it sought bankruptcy protection to reduce its debt obligations to creditors while fully satisfying its obligations to CalPERS, the California Public Employees Retirement System, which manages city workers’ retirement money. The city owes some $900 million to CalPERS in order to cover its pension obligations.
Judge Klein disagreed with the creditors and declined to dismiss, finding that the city was indeed insolvent and needed bankruptcy protection in order to perform the basic functions of a municipal government. The judge also said in the ruling that it was the creditors who had acted in bad faith, presumably referring to the fact that creditors reportedly refused to negotiate in mediation — as required by bankruptcy law — unless the city cut payments to CalPERS. They also refused to pay for some of the costs of the mediation.
Stockton is required by California law to fund its pensions, so the potential conflict between this state law and US bankruptcy law is the key issue that observers (most notably the $3.7 trillion municipal bond market) will be keeping a close eye on as the case unfolds. Since many other cash-strapped cities have similar issues with pension funds, this could set an extraordinary precedent for other cities who may want to follow suit and proceed with chapter 9 protection to restructure their debts. However, the city must still come up with a debt restructuring plan that must be approved by the judge; the creditors can also object to the plan, which they fully intend to do. While Judge Klein ruled that Stockton’s decision to continue payments to CalPERS while neglecting others was not improper, he did acknowledge that the question of how CalPERS will be treated in the city’s proposed repayment plan is a “serious issue” that will be dealt with in the plan negotiation phase.
